Mitigating Estimation Risk in Asset Allocation: Diagonal Models Versus 1/N Diversification
31 Pages Posted: 15 Jul 2016
Date Written: August 2016
Recent literature suggests that optimal asset‐allocation models struggle to consistently outperform the 1/N naïve diversification strategy, which highlights estimation‐risk concerns. We propose a dichotomous classification of asset‐allocation models based on which elements of the inverse covariance matrix that a model uses: diagonal only versus full matrix. We argue that parsimonious diagonal‐only strategies, which use limited information such as volatility or idiosyncratic volatility, are likely to offer a good tradeoff between incorporating limited information while mitigating estimation risk. Evaluating five sets of portfolios over 1926–2012, we find that 1/N is generally not optimal when compared with these diagonal strategies.
Keywords: portfolio optimization, naïve diversification, idiosyncratic volatility
JEL Classification: C13, C51, G11, G12
Suggested Citation: Suggested Citation